The Disparity between Stock and Money Markets: A Cause for Concern
This week was an eventful one.
On Tuesday, the IMF in its Jan. 2024 World Economic Outlook (WEO) update, revised upward the world economic output growth to 3.1 percent – 20 basis points higher than projected in its Oct. 2023 outlook. India’s GDP growth too was revised upward by 20 basis points to 6.5 percent for 2024 and 2025. But the projected world GDP growth is still lower than the historical forecast of 3.8 percent. The elevated central bank policy rates to fight inflation, withdrawal of fiscal support, high debt weighing on economic activity, and low underlying productivity growth were cited by the IMF for the lower projection. It expects a faster disinflation to aid in further easing financial conditions that would provide an upside to global growth. However, commodity price spikes from geopolitical shocks (Red Sea attack, War in Ukraine, and Gaza), supply disruptions, and persistent underlying inflation prolonging tight monetary conditions present downside risks to global growth.
On Wednesday, the Fed announced its decision to keep policy interest rates unchanged, in its first Monetary Policy Committee (MPC) meeting of the year. The US market had rallied over the past two months on the expectation that cooling inflation would allow the Fed to cut rates by 1.5 percent in 2024. But the Fed’s latest decision has put a dampener on this expectation. The Fed stated that, even though it is thinking about lowering rates, rate cuts are not imminent; hence, is willing to wait for more convincing evidence that the downturn in inflation will endure.
On Thursday, the interim budget was presented by FM Nirmala Sitharaman. The market response to the Budget was muted as it unfolded as anticipated. The lower-than-expected fiscal deficit target and absence of populist measures ahead of the elections were seen as long-term positives for the market. In response, the 10-year Government of India bond yield slumped to a 6-month low of 7.06 percent on the budget day. Positive sentiment and the consequent investor money flow are expected to follow gradually.
The Indian markets made a new all-time high in January 2024 despite enduring massive FPI selling: FPIs sold $2.4 billion worth of stocks during the month – the highest in 12 months. Midcaps and Smallcaps outperformed. Even though, the benchmark indices – Sensex and Nifty – were unchanged for the month, Nifty Midcap 100 and Nifty Smallcap 100 indices gained 5.2 percent and 5.8 percent respectively.
But, despite the cheerfulness, I find the current market perplexing. What makes it so is the significant dissonance between the stock market and the money market. The stock market remains buoyant – indices rising to all-time highs – and is less volatile. However, the money market rates indicate a tight liquidity situation. The money market deals with very short-term securities, typically with maturity between 1 day and 1 year. Under normal conditions, a long-duration security should yield higher than a short-duration security. However, now a 182-day Treasury bill (short-term security) yields 7.184 percent while the 10-year Government of India bond (long-term security) yields 7.144 percent. A flat yield curve is cause for concern. We should have a rising yield curve under normal conditions. Even though this trend – a buoyant stock market and a gloomy money market – has been existing for some time, it cannot last for long.
How would this disparity between the stock market and the money market be corrected?
Stock prices should decline (or corporate profits should rise) so that the premium of earnings yield over bond yield returns to a more normal level. Next, the short-term yields should drop to a lower level. But that could only be achieved through monetary actions – lowering interest rates or massive liquidity injection. Another way is a sharp spike in long-term rates but that too would require monetary interventions with disastrous consequences. It will significantly increase the cost of funds for both the government and the private sector. Many ongoing long-term projects will become unfeasible. It will jeopardize government budgets and capital expenditure. Economic growth slows down, profitability declines, asset prices decline, and unemployment might ensue.
Surely, the first option is more likely and preferable – a decline in short-term rates to a more agreeable level. But only extraordinary circumstances compelling enough will force monetary authorities to make steep rate cuts or liquidity injections as currently warranted. I presume we are under normal circumstances now and only a gradual reduction in rates is possible under normal circumstances.
RBI had reduced rates at three different times over the past decade. The policy repo rate was reduced from 8.00 percent to 6.00 percent over three years between 2015 and 2018 (a normal circumstance); similarly, the repo rate was reduced from 6.50 percent to 5.25 percent in 2019 (a normal circumstance); but rates were cut steeply from 5.25 percent to 4.00 percent within a month in early 2020 in response to the coronavirus pandemic-induced lockdown (an extraordinary circumstance). The first two rate cuts of the past decade were gradual cuts made under normal circumstances, while the third was a steep cut made under extraordinary circumstances.
I foresee that the most plausible path that will correct the current disparity between the stock market and the money market is that: 1) stock prices decline, 2) inflation remains anchored, 3) economic growth slows, and 4) RBI responds with a gradual cut in policy interest rates. If so, the result would be a more balanced real interest rate (inflated-adjusted interest rate) that neither accelerates growth nor hinders growth but facilitates sustained growth.
It would revive demand in the economy, so that household income and corporate profits increases, which encourage increases in investment spending and consumer spending that provides further impetus to economic growth. Then, stocks will have high prospective returns as valuations are reasonable and corporate profits are rising. Stocks will rise as investors gradually purchase stocks due to their high prospective return. Confidence increases as prices rise, attracting more investors into the market. However, as the increase in prices continues, stock prices will reach a level at which the prospective return is low, and stocks are no longer enticing from an investment perspective.
Get our Analysis and Insights delivered in your Inbox
AMN Capital is an investment firm. Our goal is to achieve superior investment returns by investing in the Indian stock market. Visit Us.
AMN CAPITAL 
2 thoughts on “Disparity in Markets”